ADAPTIVE MARKET HYPOTHESIS: Andrew Lo's Groundbreaking Work Combining Rational And behavioural Market Theory

Andrew Lo

Photo: Smith Business School via YouTUbe

MIT Professor Andrew Lo might be the most highly respected academic in financial theory.He’s closely followed by the most sophisticated hedge funds.  Recently, he was named one of Time Magazine’s 100 most influential people in the world.

In December, Lo published the most succinct summary yet of his Adaptive Markets Hypothesis, which he first posited in 2004 (.pdf).

His work attempts to combine the rational principles of the efficient market hypothesis with the irrational principles of behavioural finance.

It’s complex, yet extremely interesting stuff. We offer you a quick crash course in Lo’s AMH.

Lo refers to the period from the mid-1930s to the mid-2000s as 'the Great Modulation,' after the post-Depression reforms put in place to modulate financial activity.

During that era, traders believed the following about the relationship between risk and reward: it was linear, static across time and circumstance and could be accurately quantified. They also believed investors possessed rational expectations and that asset returns' could be modelled. Finally, they believed markets were efficient.

Lehman brothers suspended belief in each of these, triggering our innate flight-or-flight response.

Source: Andrew Lo

Population growth, technological changes and emerging economies have upended the stability of global financial asset prices. The most volatile period the market's ever experienced was not the early 1930s but the early months of 2009.

Lo says that periods of collective fear or greed, when the madness of mobs takes over, must now be expected. While an investor with decades-long horizons are still highly likely to see positive returns, within any given five-year period, there may be extreme fluctuations.

Source: Andrew Lo

Lo posits investors' flight to safety as a manifestation of fight-or-flight

'This process of divestment puts downward pressure on equity prices and upward pressure on the prices of safer assets, causing the normally positive association between risk and reward to be temporarily violated.'

Source: Andrew Lo

In the good old days, Lo says, investing straight down the middle of the S&P500 was an adequate proxy for diversifying.

That is no longer the case. The S&P500 stocks now move practically in lockstep.

To truly diversify today, investors must take positions in an array of assets in multiple countries, factoring in exposure instead of or in addition to asset class.

Source: Andrew Lo

Publishing accurate, objective, and timely risk analytics in financial contexts helps mitigate the effects of uncertainty.

But even then, underlying risk may still not be fully known, as was seen in the AAA ratings of collateralized debt obligations.

Source: Andrew Lo

Estimation error, regime shifts, institutional changes, and more realistic models of investor preferences and behaviour are now required to make informed investment decisions.

'As the volatilities and correlations of the underlying assets change over time, the portfolio weights change in tandem to maintain constant risk weights and portfolio volatility, reducing the potential for fight-or-flight responses because the investor experiences fewer surprises with respect to his portfolio's realised risk levels.'

Source: Andrew Lo

Lo admits that the practical implementation of his theory will be more difficult than investing under an efficient markets theory framework.

But it probably comes closest the reconciling the incomplete understanding the prevails in the current volatile climate.

Source: Andrew Lo

Here's something from NYU's legendary finance professor Aswath Damodaran

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